Mapping the cycle: where are we?

Monthly Investment Letter

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The duration of the current bull market in global stocks makes clients around the world ask “Are we overdue for a bear market?” But bull markets don’t just die of old age. To answer “yes” to this question, we would have to conclude either that valuations are far too high, or that we are likely heading into economic recession. Today I don’t think that either is a clear and present danger to the bull.

Global price-to-earnings ratios at 17.8x are close to the long-term average of 18x. This reduces the scope for significant further upside, and we take some profits by reducing the size of our overweight position in global equities. But valuations remain below the kind of stretched levels that have led to bear markets in the past (for instance global price-to-earnings ratios reached 30.6x in the dotcom era). Ratios in the 18–23x range have historically been consistent with positive returns (6%) over the following six months.

The current bull market in global stocks makes clients around the world ask “Are we overdue for a bear market?” But bull markets don’t just die of old age.

While we are now more than eight years into the current economic expansion, there are few signs to suggest the economy has run out of slack. As I detail further in this letter, the traditional catalysts for a recession – oil price spikes, government austerity, sharply higher rates, a credit crunch, or an exogenous shock – look unlikely to emerge over our six-month investment horizon. As such, we believe it is too early to call the end of the cycle and get overly defensive.

As we look further forward, a downturn will inevitably come. We believe that the most likely cause of a downturn would be a withdrawal of monetary support. If so, the risk this poses to bond prices means that investors will need to think differently about strategic asset allocations. Investors will need to ensure they are diversified across equities, bonds, and alternatives, allow for greater flexibility in investment policies, and consider long-term systematic approaches to equity hedging.

As we look further forward, a downturn will inevitably come. We believe that the most likely cause of a downturn would be a withdrawal of monetary support.

Where are we in the cycle?

Concerns that we might be approaching the end of the economic cycle stem from a number of signs which, if taken in isolation, suggest that the world economy might not have much additional room to grow. US unemployment is just 4.4%. Job openings, at 6.2 million, are the highest since at least 2000 (Fig. 1). We have started to see some central banks shift toward controlling inflation. The Bank of England could now hike rates before year-end. Corporate credit spreads are below long-term averages. And China’s debt growth, which has taken total debt-to-GDP from 140% in 2008 to almost 300% today, will need to slow at some point, potentially reducing global economic demand.

But other signals suggest a more benign picture. Global growth is currently synchronized and generally accelerating. Three-quarters of the 45 countries monitored by the OECD will experience faster economic growth this year than last. The link between a tight labor market, higher wages, and prices is less clear than in the past. In spite of all the job vacancies, US wage growth, based on average hourly earnings data, was last reported at just 2.5% in the year to August. Average consumer price inflation across the US, Eurozone, and China is still just 1.7% (Fig. 2). Although total debt levels in China have risen, households in the US and Europe have not even begun to increase leverage – debt-to-GDP has fallen from 79% in 2008 to 69% today, according to data from the Bank for International Settlements (BIS).

Overall, this mixed picture leads us to believe that the probability of a recession over the coming six months is low, and that we are mid-cycle (albeit likely closer to the end of mid-cycle than the beginning). This view corroborates with other recession indicators: the Fed’s GDP-based Recession Indicator shows a recession probability of 8.2% (Fig. 3). Global equities can still perform in a mid-cycle environment. Average global equity performance in the period 6–18 months before a downturn is 19%.

What might end the cycle?

The end to cycles has historically been brought about by: sharp reductions in net government spending (e.g. Eurozone 2011–12), oil price shocks (e.g. US 1973–75, 1990–91), credit crises (e.g. 2007–09), a major exogenous shock (such as a natural disaster e.g. Japan 2011), increases in interest rates (e.g. US 1979–80, 1990–91), or an unwinding of asset price speculation (2000–02, 2007–09).

We are mid-cycle (albeit likely closer to the end of mid-cycle than the beginning).

Today, sharp reductions in net government spending look unlikely given that deficits in the US and Eurozone have already contracted sharply (from 8.7% and 6.3%, respectively, of GDP in 2010, to 2.6% and 1.5% today), and the current policy agendas in the US and Europe both suggest more net government spending. Shale technology has made the global oil supply fundamentally more flexible, reducing the chance of an oil price shock. And valuations are close to their long-term average, not at levels historically consistent with sharp drawdowns.

We see the three most important potential catalysts for a downturn as: a credit crisis, an exogenous shock, or tighter monetary policy.

While the risk of a credit crisis should be reduced by the improvement in bank capital ratios from 7.1% in 2007 to 13.4% today, and the decline in overall developed market household debt-to-GDP from 85% in 2009 to 73% today according to BIS data, there are low-probability, large potential “known unknowns.” The perennial US debt ceiling debate will resurface in the months ahead, and the difficulty in finding common ground between fiscal conservatives and those in favor of large deficits could threaten Treasuries and the dollar. Meanwhile, the rapid increase in debt, widespread securitization, and lack of transparency over losses in China are cause for concern, even if global exposure to Chinese credit is relatively limited.

As for exogenous shocks, the Italian election is set for next spring, and we continue to monitor the North Korea situation. For indications of the likelihood of conflict, we will be watching closely for signs of increased North Korean technological development, readiness or preparations for war among North Korea’s neighbors, and developments in economic sanctions. For more see last month’s letter Waldorf Salad.

While low rates of inflation and wage growth mean that central banks can keep monetary policy relatively loose for now, sharp increases in inflation or wage growth, rising debt, or significant increases in net government spending could force their hand. As long as there is uncertainty over the “natural rate of interest” (i.e. the interest rate at which central banks are neither actively constraining or stimulating the economy) the risk of a policy error is higher (Fig. 4).

Don’t just prepare for last time

Investors need to ensure their strategic asset allocation is prepared for these potential outcomes. One part of this is to diversify across regions – reducing exposure to localized shocks or credit events. Another is to diversify across asset classes – if monetary policy causes the next downturn, bonds are unlikely to be the safe haven they were in the past (Fig. 5).

Removing bonds from a portfolio altogether is unlikely to prove an effective strategy in every scenario (they would likely remain a good source of protection in case of certain geopolitical shocks.) So we diversify our strategic asset allocation across bonds, equities, and alternatives, to help reduce the reliance on any one asset class. Within alternatives, relative value, equity market neutral, and macro/trading strategies could be the most effective uncorrelated sources of return should central banks withdraw support (Fig. 6).

Investors can also consider strategic approaches to protecting their portfolio. They include ensuring that investment policies allow for significant shifts between asset classes, or employing systematic approaches to equity hedging – limiting expenditure on near-to-the-money hedges but protecting against large drawdowns.

Asset allocation

We make two changes to our tactical asset allocation position this month. First, we reduce our overweight to global equities. Although we continue to believe that global stocks can grind higher, underpinned by robust economic growth and increasing earnings, rising valuations are reducing the possibility of significant further upside. Global stocks have climbed 15% year-to-date, about twice our expected long-term return on stocks. We therefore believe it is prudent to take some profit.

Second, in our FX strategy we reduce our overweight position in the Canadian dollar (CAD) versus the Australian dollar (AUD), taking some profit after the strong run of the CAD in recent months following the Bank of Canada’s interest rate hike. This was a non-consensus view when we adopted the trade in June. We still see the CAD outperforming the AUD, since we expect pressure on the Australian economy to intensify as weaker Chinese growth weighs on commodity prices. As a result, we keep half of this position open.

We make two changes to our tactical asset allocation position this month. First, we reduce our overweight to global equities. Second, we reduce our overweight position in the CAD vs. the AUD.

We also overweight the Swedish krona versus the Swiss franc. In July, Swedish inflation exceeded the Riksbank’s 2% target for the second consecutive month, and unemployment hit its lowest level since 2008. We therefore expect the central bank to tighten policy, supporting the krona. In contrast, we expect the Swiss franc to remain under pressure due to excess franc liquidity after years of intervention by the Swiss National Bank.

Within Europe we prefer Eurozone equities over UK stocks. The Eurozone economy has gained momentum and growth has broadened out into the periphery, more than offsetting headwinds from a stronger euro. We expect earnings growth of around 10% for the year. In contrast, the prospect of tighter monetary policy in the UK has pushed sterling almost 5% higher against the US dollar, and 4% against the euro since the start of September. With around 75% of FTSE 100 revenues coming from overseas, this currency move should keep UK equities under pressure relative to Eurozone stocks.

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